Default and Asset Correlation: An Empirical Study for Italian SMEs

Abstract

This paper addresses the estimation of confidence sets for asset correlation for credit risk assessment in the Italian market. Research on the estimation of asset correlation using endogenous default probabilities data has focused the impact of concentration risk factors, such as industry and firm size. The empirical evidence shows that assumptions underlying the Regulatory Capital formula are not substantiated and benefits receiving from the respect of the granularity could be reduced or even removed. This effect could depend on the positive relationship between asset correlation and default probability, the negative relationship between asset correlation and size, and the positive link between default correlation and default probability. The regulatory impact is that the purpose to level the playing field could be failed, setting up a regulatory arbitrage opportunity and the risk that some firms, clustered by size and industry, could suffered by the credit crunch.